A method of evaluating a company's financial performance by calculating and comparing key relationships between financial statement items.
Ratio Analysis is the most widely used technique for financial statement analysis. It converts raw financial data into meaningful relationships that reveal profitability, liquidity, efficiency, and solvency. Ratios are compared: over time (trend analysis), against industry peers (benchmarking), against standards (ideal ratios), and against budgets. Categories include: Profitability ratios (ROE, Net Margin), Liquidity ratios (Current, Quick), Efficiency ratios (Inventory Turnover, DSO), Leverage ratios (Debt-Equity, Interest Coverage), and Market ratios (P/E, EV/EBITDA). No single ratio tells the complete story — always analyze multiple ratios together.
Quick financial health check for a manufacturer: Current Ratio: 1.8 (healthy), Quick Ratio: 0.9 (marginally okay — inventory heavy), Debt-to-Equity: 1.5 (moderately leveraged), Net Profit Margin: 8% (industry avg 10% — needs improvement), Inventory Turnover: 4x (industry avg 6x — too much stock), DSO: 45 days (acceptable). Diagnosis: Company is solvent but has excess inventory and below-average profitability.
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Top 5 for SMEs: 1) Current Ratio (can you pay bills? target >1.5), 2) Gross Profit Margin (is pricing right?), 3) Net Profit Margin (overall profitability), 4) Debt-to-Equity (how leveraged?), 5) Accounts Receivable Days/DSO (are customers paying on time?). Track monthly and compare to industry averages.
1) Historical data — ratios look backward, not forward, 2) Different accounting policies between companies make comparison difficult, 3) Seasonal businesses show misleading ratios at certain dates, 4) Window dressing — companies can manipulate year-end numbers, 5) Inflation distorts comparisons over time, 6) Industry benchmarks may not apply to diversified companies.
A liquidity ratio that measures a company's ability to pay its short-term obligations using its short-term assets.
A stricter liquidity measure than the current ratio, excluding inventory from current assets to show a company's ability to meet short-term obligations with its most liquid assets.
A financial ratio comparing a company's total debt to its shareholders' equity, measuring how much the business relies on borrowed money versus owner investment.
A financial metric that measures the profitability of an investment by comparing the net profit to the cost of the investment, expressed as a percentage.
Earnings Before Interest, Taxes, Depreciation, and Amortization — a measure of a company's operating profitability excluding non-operating and non-cash expenses.
Formal records of a business's financial activities, comprising the Balance Sheet, Profit & Loss Statement, Cash Flow Statement, and Notes to Accounts.
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